My Toy Macro Model
The one where I keep talking about interest rates even as interest rates are not indicative of the stance of monetary policy.
My readers likely know that my main interest in economics is with regards to monetary policy. Below I will try to give a brief overview of how I think about macroeconomics in today’s world. Most of this will be in line with mainstream thought and I will point to any discrepancies from what you’d hear from a regular central bank.
Interest Rates
Interest rates are the policy tool used by the vast majority of central banks. Understanding their composition and macroeconomic effects is key to “getting” both mainstream and heterodox macro views.
First we must draw a distinction between nominal and real interest rates. The nominal rate is what you see around you. The Fed as of writing this piece has a lower bound for the federal funds rate of 4.5%. You can get a mortgage with 7% interest rates. These are all nominal. On the other hand real interest rates are the nominal rate minus inflation.
Real Interest Rate = Nominal Rate - Inflation
Quiz time: what would the real rate be on a mortgage with 7% nominal rates?
If you subtracted the current inflation rate of 2.6% from 7% and got 4.4%, then you’re wrong. 2.6% was the inflation rate in the last 12 months. To calculate the real rate for a mortgage you’re getting now you need the inflation rate over the future. As you may have noticed, the future has not happened yet, so we have no idea what the real interest rate is. As a result, a better way to phrase the above equation is with expected inflation (how much inflation we think there will be).
Real Interest Rate = Nominal Rate - Expected Inflation
Now for the big question: how do interest rates affect the economy? The answer is that high enough interest will generally lead to less inflation and higher unemployment while low enough interest rates will generally lead to higher inflation and lower unemployment (at least in the short-run).
It’s important to note here that I used the words high enough and low enough. This is because plain “high” interest rates are actually a sign that money has been easy, whereas plain “low” interest rates are a sign that money has been tight.
What Makes a Man Turn Neutral?
To understand what the above means, we should first note the concept of a “neutral” or “natural” rate of interest. I will first note that the existence of a neutral rate is heavily contested by more heterodox (and even some mainstream) economists. Nevertheless, central banks believe in it and often reference it, therefore it is essential to understand.
Imagine an economy where the central bank does not interfere. The currency in this economy is independent of government control (perhaps it’s gold, bitcoin, or a secret third thing). The interest rate in this economy will be set by the market. This is called a natural interest rate.
Now suppose an economy that is “stable”. Inflation is stuck at 2%, interest rates are unchanging at 4% and nothing is happening. Here 4% is the neutral interest rate. The one that keeps inflation unchanged in the long term.
Economists often implicitly conjecture that these two are equal and denote them by r*.
Natural Rate of Interest = Neutral Rate of Interest = r*
Note here that there are really two natural interest rates. The natural real rate is what really matters. But we can also denote the natural nominal rate by i*. The equation relating them should not be surprising to you.
i* = r* + inflation = r* + expected inflation
Note that we need not replace inflation with “expected inflation” because when interest rates are at their “neutral” level inflation shouldn’t really be changing.
Here’s how to interpret these two:
When the real interest rate is equal to its neutral value inflation will remain constant (regardless of where it’s at, be it 2% or 20%).
When the nominal interest rate is equal to its neutral value inflation will remain constant at some specific rate, depending on your nominal interest rate.
In other words, suppose you have an economy with a 4% neutral real interest rate. If the real interest rate is at 4%, then inflation could be 2% and unchanging (with a 6% nominal rate) or 20% and unchanging (with a 24% nominal rate). It’s consistent with whatever inflation number you want. But if you’re at a neutral nominal rate of 6%, then that is only consistent with 2% inflation and not 20%.
Now we can finally go back to the meaning of “high enough” and “low enough” and state the following conjecture:
When nominal interest rates are higher than the neutral level, inflation will keep falling. When nominal interest rates are lower than the neutral level, inflation will keep rising.
Why does this statement make sense? Imagine that interest rates are lower than you would expect given market conditions. This means that people will want to borrow and spend more money than they would normally. This will lead to higher demand for goods/services and higher inflation. Now inflation is higher than before while the nominal rate is unchanged, so we’re even further below the neutral rate. Now people will borrow even more and you get an inflationary spiral. You can reverse this story to explain why higher-than-neutral interest rates would cause falling inflation (and eventually deflation).
In other words, if the Federal Reserve wants to lower inflation it must do the following: (1) figure out the neutral real interest rate in the economy (2) figure out what inflation expectations are at (3) add the two together to get the neutral nominal interest rate (4) raise the nominal rate above that number. And again, if you want to make inflation higher you can do the exact opposite.
Now we can ask a couple questions that should be bugging you:
What determines the neutral real rate of interest?
What determines inflation expectations?
Not Sure Where Neutral is, But Determined to get There
Assuming the neutral interest rate is equal to the natural (or the “market-determined”) interest rate, it should depend on people’s willingness to lend/borrow money at different rates. Let’s go through a few obvious factors:
Economic growth. Assume you expect to have 10x more money next year than you have right now. Then you will probably not be willing to lend at a low interest rate, since you value a dollar today more than a dollar tomorrow (because you’ll have so many more dollars tomorrow!). As a result, higher long-run economic growth should lead to a higher neutral real interest rate.
Risk. If you think a creditor is unlikely to repay their loan, then you will charge them a higher interest rate. Therefore, Argentina will have a risk premium on its interest rates because it has defaulted so many times. On the other hand, the US has no such risk premia.
Time preference. This deals with how much people preserve to consume now vs later. More impatient individuals (and markets) will serve higher interest rates.
Government deficits/surplus. If the government borrows vast amounts of money, it raises the demand for credit and, therefore, the natural/neutral interest rate. Likewise, if the government runs smaller deficits or even a surplus, the neutral rate will fall. This is primarily how fiscal policy affects the economy in the monetary policy focused story (we will elaborate on this further down below).
The middle two here don’t change too often. The central bank’s job here is generally to try and figure out the growth rate of the economy (or in fact, the expected growth rate, as that determines how people will borrow/lend) and the impact of government deficits on the neutral rate.
No One Expects the Spanish Inflation
What about the determination of inflation expectations? Not to be a bummer but there is no good answer to this question, but what we can make a few key statements:
What matters are the expectations of large financial institutions and not necessarily households. These institutions borrow the largest sums of money to invest in their projects. It is their expectations that you care about and not those of your average John Smith.
Inflation affects inflation expectations. Shocker. If people observe high inflation for long enough then that will be embedded into their expectations of inflation. Therefore, to get inflation down you will need higher interest rates then you would have otherwise.
The central bank can directly affect inflation expectations by credibly committing to higher/lower inflation. This point is key. It tells us that the Fed might not change interest rates at all, but get interest rates above/below the neutral nominal rate by affecting where the neutral nominal rate is. Jerome Powell could do this by banging his fist on his desk and yelling that he will do EVERYTHING in his power to get inflation down. This will likely make banks panic and revise down their inflation expectations.
Fiscal Policy
But what about government spending? Isn’t that at the center of Keynesian macroeconomics? You’re correct, government spending is an often-discussed topic in macroeconomics, but remains controversial. The mainstream textbook story regarding fiscal policy consists of two key elements:
Fiscal policy usually can’t affect inflation (and the broader economy). This is because the central bank has an inflation target and will do everything in its power to reach that target. If the government raises the deficit then this will raise demand for credit, raise the neutral real rate and prompt the Federal Reserve to raise interest rates to prevent fiscal policy from affecting inflation. This is what some relatively heterodox thinkers refer to as “monetary offset”.
Fiscal policy can affect inflation (and the broader economy) if interest rates are at 0%. To better understand, pretend that due to some strange circumstances (e.g. a recession) the neutral real rate is at -3%. Suppose further that inflation is at 2% and the nominal rate is at 0%. In this case the real rate will be -2%, which is still above -3%. Conventional monetary policy tools will fail here since the Fed cannot lower the nominal rate below 0%. But if the government raises deficits significantly then the neutral real rate may rise up to -1%, making the Fed’s interest rates “low enough” to have an effect.
Of course, both of these points are hotly contested. Many argue that the Fed isn’t good enough at monetary offset, which means that fiscal policy matters more than it should. Furthermore, those in my macroeconomics bubble don’t really believe that fiscal policy can matter even when interest rates are at 0%. We would generally appeal to alternative targeting systems and unconventional policy tools.
Putting it All Together: 2008 vs Covid vs Disinflation
Let’s try to use these tools to analyze the three big macroeconomic events of the past two decades.
In 2008 the United States was hit by a major recession which greatly reduced the neutral real interest rate. The neutral real interest rate probably went into negative territory. The Federal Reserve was behind the curve in lowering interest rates and only reduced the federal funds rate to 0% in December. This likely made the situation much worse because interest rates were above neutral for a prolonged period of time. Over the next 8 years interest rates had to remain at 0% just to have inflation stay close to, but below 2% (indicating a neutral real rate near -2%). The fiscal response was also not that large. Therefore, the recovery from the Great Recession was very slow.
On the other hand, in 2020 when the US was hit by Covid-19, the Federal Reserve brought interest rates to 0% in April. They soon followed this up with a switch to a “Flexible Average Inflation Targeting” regime, which also helped raise inflation expectations. Furthermore, the US deficit to GDP ratio was 14.6% in 2020 and 11.7% in 2021, indicating a huge fiscal response which helped raise the neutral real rate higher than it would have been otherwise. As a result, the economy recovered very quickly and inflation also went back to target.
…In fact, it turns out the US economy had too much stimulus from both the Fed and fiscal policy. In February of 2022 interest rates were still at 0% while inflation was huge at 7.9%. This was during the heat of the “Team Transitory” vs “Team Persistent” debate. If we naively subtracted inflation from the nominal rate this would imply a real rate close to -8%, definitely much lower than any plausible neutral rate. So the Fed was forced to keep raising interest rates. Nevertheless, inflation kept rising for a few months because the Fed’s 2.25% rate in August 2022 was still below any reasonable estimate of the neutral rate. As it (thankfully) turned out, inflation expectations had not turned too high and we quickly got back to something close to 2.5% inflation. The Federal Funds Rate hit its peak of 5.25% in August of 2023. This does not mean that monetary policy was kept constant. In fact, as inflation kept falling this 5.25% was becoming ever-higher than the neutral rate. Finally, to make sure disinflation remained painless the Fed began to lower interest rates in September. The idea here was to maintain the Federal Funds Rate just above the neutral rate (as the neutral rate was falling).
So there you go. You should now be able to understand interest rate dynamics.